Saturday, May 16, 2009

The Exuberance Glut Or The Dollar-Euro Short Squeeze Race

Much speculation lately focuses not so much on what the stock market will do (the answer to that should be self-evident, especially once shorting stocks again becomes a practical reality), but what the impact of recent economic policies will be not just on inflation (regional or global), but also on that most sacrosanct piece of paper, the U.S. dollar.

In order to approach this question from a different angle than the conventional theoretical wisdom of Quantitative Easing being the end all be all explanation for the mid- and long-term fate of the U.S. currency, an approach that has much more practical credence is that presented by David Roche of Independent Strategy, which demonstrates overall liquidity, defined as claims on goods, services and assets, as an inverted pyramid.

At the bottom of this pyramid is the power money of reserve cash - liquidity created on the balance sheet of central banks. As noted, it accounts for a mere 1% of global liquidity, and thus the impact that the Fed and other world central banks will have with existing policies that address merely this aspect of liquidity will be, at best, massively muted. Above this is the liquidity bank loans liquidity, created through the conventional credit multiplier mechanism of commercial banks. Above that still is the liquidity created by securitization of debt. This experiment, gone horribly wrong, allowed claims on illiquid assets to grow further relative to the reserve money in the system. This is precisely the layer that the Fed and Treasury are trying to revive with the various TALF iterations, so far unsuccessfully. And at the very top of the pyramid is the layer of interest rate and credit derivatives: a means whereby institutions were able to maximize claims on physical and financial assets, by insuring against losses, without increasing precautionary reserves either of capital or reserve money.

In order to fully understand currency and price movements, one has to realize that the securitization of debt, and creation of derivatives amounted to a huge virtual printing press, primarily fueled by a massive increase in risk appetite which allowed for a huge expansion in the value of claims on financial assets and goods and services. It is worth pointing out, that the Fed has little to no control over this "printing press" at this point, which at last count was responsible for over 90% of the liquidity in the system.

Show me the money

In a fiat currency system, as previously pointed out, money is nothing more than a claim on assets, goods and services, and, most dangerously, money created at the top of the pyramid, in electronic form or otherwise, is just as real as the coins and physical dollars held at the basement of the Federal Reserve. The propagation of money higher in the liquidity pyramid explains why all traditional measures of money supply are not only inadequate but likely flawed: orthodox measure of money supply only include the first two pyramid tiers and completely ignore the major ones at the top. This is a major problem as analysts and economists who rely on these traditional "money metrics" only get a glimpse of 7% of the global liquidity in circulation. As for the the balance? The effect of creating an overabundant supply of money (that was not figuring into any monetarist policies) was that the price of money fell relative to assets, commodities and goods, services and labor. Therefore not only did generalized price inflation accelerate, but so did the increase in asset prices as well as the 6 year commodity bull run over the past 6 years.

Now hide the money

The liquidity pyramid's expansion was left unchecked for many years, as a result of loose regulation, low interest rates and a variety of other factors. At the core was the pro-cyclical risk appetite increase accompanying economic booms. Now that we are either in a recession or depression, this appetite has vanished (absent a few pockets of precisely orchestrated equity follow-on cluster bombs). Risk pooling and credit insurance, central to easy money creation, have essentially ceased (accentuated by the Lehman bankruptcy): one need only look at the total CDS notional in circulation which has collapsed from over $60 trillion at the end of 2007 to less than $30 trillion currently (according to DTCC). In short, 2008 was characterized by a massive destruction of money, and this process will likely continue well into 2009 and 2010.

Where does the dollar fall into all this?

The dollar's long decline from 2002 to 2008, most evident with its comparison to its recent rival, the Euro, reflected that the creation of money through securitization and derivatives was mostly denominated in U.S. dollars. And, very usefully, the U.S. current account deficit, which peaked at $844 billion in Q3 2006, recycled these dollars into the global economy, which coupled with the current account surpluses of Europe (only recently moving to deficit) and Japan (surplus for every year of the past decade), made the dollar pervasive. A "superabundance" of synthetic dollars had the effect of depressing its price relative to other fiat currencies in the same way it depressed their values relative to goods, services and commodities.

This process started to unravel last July. Much more than explanations provided by economic and rate expectations, the move has been too sudden and too large, and the most likely "real world" explanation is that the dollar has been caught (does this ring a bell) in a massive short squeeze as the liquidity pyramid has started to shrink. Dollars have been destroyed on the supply side much faster than any currency as i) more had been created and ii) the trust collapse occurred first and most with regard to financial institutions' dollar claims. As dollar supply has shrunk (and will continue to shrink massively) and price has risen, the dollar has appreciated versus all other fiat currencies.

In truth, it is not just a question of supply: as risk tolerance and trust have both collapsed, the demand for dollar cash has expanded.

As the dollar was the funding currency of choice for the entire world, everyone had gone short the dollar: the liquidity pyramid's growth meant that dollar funding was easily available and cheap. As long as loans could easily be rolled over and interbank borrowing was cheap this was not an issue (real LIBOR, not the manufactured number that the member banks provide BBA currently, offloading funding risk from themselves onto their sovereign, with the expectation that the Fed or BoE will constantly bail them out). All promptly ended with the failure of Lehman. Ever since then, banks have been scrambling to cover dollar short positions and replace them with increasing holdings of dollar cash: the rapid increase in the dollar price has been merely the confluence of a contracting supply and an increase in demand. Econ 101.

So what is next

At some point in the not too distant future, this process will end. Frighteningly for the Fed, as more dollar claims are destroyed (the collapse of asset prices in dollar terms, better known as deflation) the speed at which dollar liquidity is shrinking will slow relative to its next most popular cousin - the euro.

It is difficult to predict at what point we will reach the dollar/euro inflection point. As the QE results imply, the Fed is running out of arrows to even manipulate the first two tiers of the liquidity pyramid, and as deflation accelerates, it is very feasible that the dollar's appreciation will soon be limited. One thing that is certain, is that market participants will soon move from focusing on dollar claims to those denominated in euros, leading to a squeeze in the euro (granted of less violence and strength than the dollar's).

Of course it is difficult to evaluate the real state of the liquidity pyramid, especially since there is no way to track the true state of the money supply/demand in the 3rd and 4th tiers. Therefore, the only way to test any hypothesis is by looking at the behaviour of actual outcomes to discern if the underlying premise is in fact getting traction. The best that can be done is to look at leading indicators being tracked and determine when the money being destroyed becomes denominated primarily in euros than dollars. A major question here is whether the dollar and euro respond more to interest rate than risk.

Currently risk seems to dominate. Negative US events translate into dollar strength not weakness even when US rates and yields falls relative to those overseas. This must change before there is a switch in the dollar-euro outperformance behavior. And comparably for the euro, it needs to decouple from negative econ news in the same was the US currency has in the last several months. Once that occurs, and accounts start amassing euros, the dollar's drop will be just a matter of time.

In subsequent articles, we will examine the impact of liquidity on inflation, the unprecedented onslaught in UST issuance which at last check has gone parabolic, the impact of monetary policy on government borrowing, and also the greatest unknown of all: China. Sphere: Related Content
Print this post
blog comments powered by Disqus